Our PMs spend a ton of time on research and portfolio reviews, and I’ve made it a habit to grab 30 minutes to ask what they’ve been seeing. Given market conditions, we opened it up to advisors to make sure we were tackling the most common things on their minds. Joining me:
- JD Gardner, CFA, CMT Founder/CIO
- John Luke Tyner, CFA Fixed Income Analyst/PM
- David Wagner III, CFA Equity Analyst/PM
Key topics covered:
- Interest Rates
- The Fed
- Valuation Compression
- Earnings Outlook
- Risk Mitigation
- Volatility Environment
- End of Year Opportunities
- Stocks vs. Bonds vs. Cash
Always fun for me, but ultimately for the benefit of the thoughtful advisors who keep us busy supporting their efforts. Full transcript below, beware transcribing errors and verbal slips!
Derek:
Good morning. I’m in Charlotte, so it’s 11 o’clock my time. But, I think we got a couple in the central zone as well, which is 10 o’clock. But, we just thought with everything going on, it’s probably, we preempt quarter end and just go ahead and talk now. Obviously, there’s a ton going on in the market. Stocks, bonds, volatility, everything. We’ve got three of our guys from the team, CFAs, JD Gardner, the founder, Dave Wagner, the equity specialist, John Luke Tyner, the fixed income specialist. So we’ll, we’ll be able to cover all bases and really, I just want to have a discussion. If you’re a client, you know that we do write some formal write-ups as the quarter ends and we get into October, and we have calls with some of you, more one-on-one type calls. But, it’s just there’s a lot going on and it warranted getting everybody together just to have a little discussion.
Derek:
I do have to read the disclaimer. The opinions expressed during this call are those of the Aptus Capital Advisors investment committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques, based on changing market dynamics or client needs. More information about Aptus Investment advisory services can be found in its form ADV part two, which is available upon request. We can cover, there’s a lot of interest in all areas, I think maybe we just start with a general picture of what’s going on. The Fed’s driving things, that’s obviously been the driver, so maybe we start with fixed income, and John Luke, if you want to talk through some of the stuff that you’ve seen coming out of the Fed meeting, and then that’ll flow right into equities and vol, and everything else.
John Luke:
Yeah, no I think it’s the most important backdrop that we’ve got. The pressure that we’ve seen and risk assets really can’t drop off, until you see some sort of abatement in the rise in yields. And so, we’ve obviously seen 10 year yield hit new highs, we hit 4% the other day, which was a high since 2010. You’ve got the Fed fund rate at 3%, up from zero in March, so we’ve got 300 bibs of tightening over seven months and there’s more expected to come, which continues to lift the longer end of the yield curve higher. So, ultimately, if you take a step back and look at what the Fed’s dealing with and really they let inflation get too hot, and Central Bank’s mandates are to keep inflation in check and keep pricing around a 2% type of growth level, and we’re at 8% or 9%.
John Luke:
And so, there’s a big problem, and Chairman Powell has just reiterated that he will continue to tighten rates until that we see inflation pressures move lower, and even if that comes at some pain to risk assets and financial markets, and ultimately the job market. Job market is still very hot, we’ve talked a lot about this internally, but this move we’ve seen in risk assets or financial assets, hasn’t really been seen in the real market yet, and the real economy continues to be relatively strong and that’s what the Fed’s fighting against, is, the economy was running very hot the last couple years and we’re slowing it back down.
John Luke:
So, high level overview is that the Fed’s going to keep at it, until inflation gets back in check or they break something, and you’re starting to see some breakage signs appearing and you saw that with the Bank of England last night, making a pledge to interfere on the long end of their yield market, so effectively, some sort of yield curve control. And so, I think last point is, just the inflationary pressures that we’re seeing and the volatility of inflation, typically leads to a lot of macro uncertainties and that’s why you’re seeing this pressure in yields that we’re seeing. It’s pretty normal, given the backdrop that we’re facing, for yields to move up and volatility to be relatively high.
JD:
Two points, Derek and John Luke, probably harp a little bit on this, because I think this is probably the biggest thing we can talk about. Number one, Bank of England stepping in with a version of yield curve control, that’s a big deal. It’s like they’re stepping into a pretty inflationary environment, which is kind of what the Fed has said that they would not do, so they’re kind of the first to… Rates coming up like they are, things are going to probably break. You’re starting to see some of that, and so they were pretty quick to step in, and that’s brand new news, so there’s still some things to digest there.
JD:
But, one thing John Luke said that I think we need to spend time on is, as real yields are coming higher, it tends to… There’s a correlation with real yield rising and equity multiples dropping, and JL, can you, number one, walk us through real yields, and then walk us through the relationship with valuations and the rationale behind that? I’ll jump in too, but I think that’s an important point to make.
John Luke:
Yeah. So, the last 10 plus years we’ve been in a negative real yield environment. And so, what that’s simply saying is nominal yields minus inflation. And so, the real yield is simply accounting for, what’s your other alternatives out there, and then how accommodate are financial conditions, and central banks and governments. And so, the last 10 years we’ve been in a QE type of environment, where yields have been held low. We’ve seen central banks, basically step in to interact against any sort of market instability. And so, their accommodation to markets has just led to a really easy financial condition. As we look forward, you’re in a higher inflationary regime, and in turn, interest rates are moving higher, and in turn with that, asset values are impacted negatively. So, I think what’s important from here is, if you’re willing to lend money at negative real yields, that means that you’re giving a dollar and you’re being promised to receive less than your dollar in real value, in the future.
John Luke:
I think just simplifying the definition of that, it doesn’t make sense. You would never do that in a rational… A rational investor would never give someone a negative real return, or allow to receive a negative real return. And so, as you’ve seen real yields being held so low, you’ve seen multiples expand higher and higher, that’s when we saw it 21, 22 times multiple on the S&P 500 last year, and so this year, you’ve seen real yields move higher as nominal interest rates, so the stated interest rate on treasuries that we see moves higher, so real yields have come up. And so, what that’s done is, it’s brought the multiple on the S&P 500 closer to 15 or 16 times. I know Dave will hit on that. But, what we’ve seen so far this year, is just a re-pricing of higher real yields. And so, real yields across the curve are positive, and they’re actually about 1.5% on the 10 year bond, which is the highest we’ve seen in a long time.
JD:
To simplify even further, if a security is nothing more than a claim on future cash flows to get to the price today, you take those future cash flows and you have to divide those by discount rate. And so, when real yields are increasing, what happens is your discount rate, you can think of it, your rate required as an investor to be compensated to tie your capital up in a security, your demand, your hurdle rate, your discount rate goes up. So, if you take those cash flows as enumerator and you put a higher discount rate on that to get back to today’s price, it goes lower. And so, I would argue a lot of the things… Look, when money’s free, Peloton’s worth $35 billion. When money’s not free, Peloton’s not worth $35 billion. That’s a real world example. You’ve seen pockets the market and maybe I shouldn’t have set a single stock, because I know this is compliance no, no.
JD:
But, you’ve seen certain parts of the market now, for probably a year plus, be absolutely demolished because discount rates are moving higher, therefore valuations are moving lower. The areas of the equity market specifically that’s more susceptible to the damage that can occur from that, is obviously the very long duration equities, that you’re hoping their addressable market is as big as they say and their growth is as large as they say. And so, you’ve seen those types of companies, and I’m done naming specific names, but really hurt and money flow, and the equity markets to more value oriented stuff, real assets, it’s a different regime than it has been for the last 10 years.
JD:
But, obviously, rates rising affects fixed income too, and it’s worth pointing out, before we get into anything, equity markets are off as I’m talking, probably 23-ish% on the year, but long term treasuries are off 30%. AGS down, whatever it is, 16%, 17% year-to-date, so rising rates is, it’s not like… The inflationary pressures that we’ve seen, have brought a lot of the potential issues to the surface and it’s hurt assets, your traditional risk assets, equities, your traditional conservative assets, everything’s been hurt year-to-date, just because of what we’ve talked about so far.
Derek:
An issue there, it brings up a good point, because here we are, end of the quarter when pretty much any of us that have been in the business as long as we’ve been in the business, when you come into a quarter and the S&P’s down 20 plus percent, you’re thinking, hey, I’m going to rebalance into some more equities, because I was a 70, 30 and now I’m a 66, 34 because stocks have come down. Well, now, we’re in this environment, where are you pulling that money from? My safe money is down just as much as my risky money.
Derek:
So, I think that’s really probably one of the bigger challenges that’s happening with a lot of the advisors that are out there, in a traditional diversify rebalance, and you’ve talked about this for years, bonds aren’t necessarily safe assets, and it’s nice to have another source of cash when you do get these kinds of opportunities. I don’t know if any of you want to talk about what the valuation looks like, or where you can find other sources of funds, but I think that is a pretty key topic here, as we go into the fourth quarter.
David:
Yeah, I’ll talk about valuations on the equity side too, but I think a lot of the microcosms of what we’ve been speaking about, what JD just spoke about, what John Luke just spoke about, in regards to the fixed income market has been interest rates. I think as we continue to learn over the span of this year, what is the microcosm driving any type of movement in the equity market? It is also interest rates here. So, I was prepping for this call like, hey, if we’re trying to have this call at the end of the quarter, let’s talk about this quarter for a second, and more importantly, what is my biggest takeaway from this quarter? It wasn’t the fact that we saw QT increase in 95 billion, it actually wasn’t the route that we really saw in the markets here lately, both on the equity and bond site.
David:
What I was focusing on, was actually, let’s look at that bear market rally that we saw between June and August. In fact, it was not a new market whatsoever, we saw stocks rally 17%. So, why do they rally 17%? That was the big question that I want to answer here. What is the culp report? It’s actually very simple. The market’s all lower rates, we saw the 10 year drop from 3.5% to 2.5%. And so, this really isn’t rocket scientists. If you look at what we’ve learned, as investors from 2008, basically, to the beginning of this year, that investors have learned that lower for longer rates really can hide a multitude of problems.
David:
Right now the market, as John Luke alluded to, we have a lot of problems in this market are probably the most that I’ve ever personally seen. We structure higher inflation for the first time in 40 years. The biggest monetary policy shift really, since the beginning of the Volcker era, and these are really mortal sins. Not only does market have mortal sins right now, there’s a lot of [inaudible 00:13:23] sins out there with global growth, slow down, midterm election, an underdeveloped ecosystem, definitely in energy, and not to mention, a geopolitical war. So, it’s really going to become interesting to see, given all these sins in the market, is the market going to go through reconciliation for these sins?
David:
We’re seeing rates increase, so we’re starting to see these problems really occur right now, and that’s why the valuation, to go back to the genesis of this question, that’s why we’ve seen valuations substantially come down. It hasn’t been from earnings growth whatsoever. Earnings growth is still very apparent in this market, since the beginning of the year. Earnings growth for 23 is now up 7%, 8%. It’s come down slightly here, recently from $253 and 23 to $243. But, all of the valuation compression we’ve seen this year has been due to sentiment, basically, surrounding rates.
JD:
That’s the point that I was trying to make is… And we hadn’t really talked about that, is if S&P earnings are at two, whatever the estimates are now, what is the estimate right now, Dave? 240? Consensus? Somewhere around there? If 2023 estimates are 240 on the S&P and real yields are at 1.25%, that’s a different valuation environment than if the S&Ps at 240 and real yields are at zero. Obviously, that’s the point I was making. If real yields are higher, valuations are probably lower. And so, the two components of that is, okay, what are earnings going to be? Do we think are earnings really going to be 240, or are they going to be 200? We don’t have that answer. But, then the second side of that is, all right, we don’t know what earnings are going to be, and then what are real yields going to be?
JD:
I think there’s obviously some relationship there, but when you look at the S&P now, I think we’re at 3,700, somewhere like that. Those types of things are what we’re looking at to get an idea of, hey, what does it take for us to see 4,000 or higher again on the SPA, and realistically, when do prices, when does valuation get really attractive, if we’re going to continue to see damage and risk assets from rising real yields? There is an area, and this is the hard part, Derek, you have to be prepared for valuations to reset lower and for forward looking potential of returns to get more attractive, you have to be able to allocate into that, and a lot of times, getting from here to there can be really painful and we’re seeing that, we’re living through it right now. But, that’s like, if there’s a silver lining in everything that we’ve said so far is that future returns, you’ve got fixed income to a point now, where I think a lot of the risk, the majority of the risk, in my opinion, has been sucked out of the market.
JD:
You can still have damage in fixed income, but they should start to act like bonds again, meaning 0% to 3%, there’s certain damage to bonds but 3% to 5%, it’s a different level of damage, a much smaller level, just the way interest rates going up hurts bond prices. So, whether there’s more damage and equities to come, I think the most investors that have exposure to traditional, fixed income and equities, a lot of the pain is in the rear view, and some things that’s sometimes that’s hard to digest, especially when the here and now of headlines and whatever could potentially happen. Markets are forward looking, very much further than today’s headlines, and sometimes when you’re dealing with clients, it’s hard to communicate that, hey, we’ve weathered this storm as good as possible, now is not the time to pull the rip cord, because future returns are actually pretty attractive.
John Luke:
I think too, just the one comment on that, when you look at what earnings are derived from, at the corporate level, they’ve got drivers to continue to push through cost increases and price increases to us, at the consumer level. Obviously, that’s why inflation keeps running higher. At the bond level, there’s no repricing of that interest rate to go with higher inflation or as rates rise, your bond is worth less and less. And so, as we look forward, I think it shows the importance of having allocation or maybe even an over allocation to equities across portfolios, and doing so in a smart way. But, even if forward looking returns are less because inflation is higher, your stocks are giving you a better bet of meeting those long term objectives, rather than bonds, even though yields are a little bit higher.
Derek:
So, we talked about stocks and bonds, but obviously we talk a lot about volatility as an asset class, and it’s been kind of a weird year. The market’s been crushed, bonds have been crushed, there’s a ton of volatility there. VIX is up, it’s up a little bit in the past few days, but it’s not like it’s 40, 50, 60 we’ve seen at the end of other bear markets. So, does that mean we got a long way to go, or is it not going to have that spike? What are you guys seeing… You obviously live in the vol space, so I’m curious your thoughts there.
JD:
Yeah, we talk about there’s different types of hedges. So, when people say we’re long vol, we’ve few vols in asset class, we like to hedge, you could be saying one of 1,000 different things. What’s really worked this year is, much higher delta hedging, so closer to the money, if the SPA is at 100, it’s been very effective to be at 98 and have higher deltas associated with that hedge, as the markets have grinded lower. That’s kind of what you’ve had to do. Now, the big thing in this environment… Number one, we are 100% advocates of hedges in this environment, and thankfully at the model level, our allocations have held up as well as they possibly could have, given what’s happened to both risk and conservative assets, and the reason for that is because of our hedging. There’s no other way to explain why we’ve been able to sidestep some of the damage this year, and it’s because of the hedges.
JD:
But, the most effective hedges when the VIX, when the level of vol has a lid on it, in general, just because we can talk about a million different ways why that’s the case, which probably we don’t need to get into on this call. The big thing is, you have to be higher, you have to be closer to the money and have higher delta hedges, but you have to be ready to monetize them, and that’s a huge, huge thing. If we are going to be in this range-bound market, I think it makes sense to have protection on the bottom and to be able to sell into some of this elevated implied VOL on the high end, and so we’ve doing a ton of that, at the individual fund level, and then obviously that translates to the overall model level, I think.
JD:
This is an environment where simplified, the three ways you can earn return are yield growth and valuations expanding, valuations can contract, which we’ve seen, but if yield… Yields are improving, mainly on the fixed income side, growth, growth is probably not going to be the easiest thing to find, as easy it has been the last decade, or so. And then valuations, if it’s going to be more of a headwind and less of a tailwind, there has to be different return drivers. And so, to your point, Derek, I think owning volatility as a protection mechanism on the downside, is beneficial and can be a driver of returns and following markets. But, then you can also have, if we’re going to have a choppy market, you can also use volatility, you can sell it at higher implied vols, because of some of the choppiness that we’re seeing. And so, that’s a way you’re really injecting a different driver of returns into portfolios.
JD:
Last point, and I think you kind of touched on this Derek, I’m not going to name specific funds, and all that, but we’ve been able this year to monetize a significant portion of the hedge’s effectiveness and you’re able to add that back into equities at lower valuations. So, if you pick a random stock and said, “Hey, would you rather buy this stock at multiple of 15 or a multiple of 20?” Well, the answer if no changes to the underlying business, I’ll take the 15 multiple. And so, the only way that you can actually do that, unless you have cash on the sidelines, which is obviously being eroded by inflation right now, is to have something that benefits when valuations are resetting lower, and that’s the only way we know how to do that, is having volatility in place.
Derek:
One thing I didn’t point out earlier, but we do want questions, so if anybody that’s participating in the call, there’s a Q and A box, throw something in there, and we’d be happy to answer it. I also thought, since I know a lot of advisors kind of like our charts of the week and some of the stuff that we share, and some people are more visual versus just listening, I grabbed a few of the charts from the past couple of weeks and thought maybe as we wait for questions, maybe we just rifle through some of them, and if you have a hot take from them, or it’s something that you think plays into our thinking, going into the fourth quarter, maybe just hop in and discuss.
Derek:
I’m going to pull up some charts, I pulled up 8 or 10, and we’re not going to go five minutes on each one, because we don’t want to keep everybody here for an hour. But, I think it’d be a fun thing to go through and just hit some of the key things. It’s an unprecedented year, you’re going to see all these different charts and graphics and memes that are going to say, hey, the market’s never done this before, or this is the first time we’ve ever seen this. So, I guess… All right, so this is market expected trajectory for Fed fund rate. Obviously, has gone up a little bit, in the past couple of months.
John Luke:
Yeah. Real quick, the market obviously expected back in that rally in June, the middle part of June, July and August, that the Fed would pivot in some form or fashion and keep rates a little bit lower. Well, obviously, the last two months have really shown that that’s a fallacy, and you can see that just the expectations of how high the Fed’s fund rate will get, as well as how long it will stay elevated, just continues to increase. That’s important, in terms of weighing against asset valuations and keeping real yields higher, which is a goal of Chairman Powell, keeping real yields positive looking forward. So, that’s restrictive territory for financial conditions, so needed to bring down inflation, bad for asset values.
David:
I think the wildest thing about that chart is if you go back to January of this year, John Luke and I were listening a call by Jamie Diamond, and he was thought to be kind of crazy to be projecting prognoses, in the fact that hey, you know what, I think we could have five hikes in 2022, and what we surpassed that just over the last two months. It’s kind of wild just to see the expectations increased substantially, in the first half of this year, to where they are now.
Derek:
Nobody believed it, everyone said there’s no way they’ll-
John Luke:
No. I think he said Fed funds would get 4% plus, and everyone thought he was crazy. That was when we were at zero. And then, obviously, if you look at any of the Fed’s projections, if you pulled this back and looked at it, where it was last November or even at the beginning of this year, Fed was expecting three hikes.
Derek:
Exactly. Okay, so what is this? It’s a bond chart, so I’m guessing JL, you got something to say here?
John Luke:
Yeah, yeah. So, really just showing the monumental move, we’re talking about 150 basis points in move in the 10 year yield, in roughly a quarter. It’s just unprecedented. If you look back to 2013 to the taper tantrum, that’s really the most recent example we’ve got of such tightening and financial conditions, and such a high movement in and both nominal and real yield tire.
Derek:
Not a good-
John Luke:
I feel like I’m hogging the mic here.
Derek:
It’s all right. Not a good year for the TLTs of the world and some of the other long duration stuff.
JD:
A big one to point out on this one, Derek, is obviously you can see the long dated stuff has just been hammered, but risk parity has been a relatively big… It’s attracted some assets, and things like that, but look at the risk parity ETF. A risk parody fund’s not supposed to be down 32% all year, 31.4%. You could show chart after chart of the both sides of your coin, your risk assets and your, quote unquote conservative assets, have just been hurt.
Derek:
We touched on this a little bit, bond vol has been off the charts, currency vol is just crazy right now. Stock vol has been… Seems like it’s high but not really, they haven’t seen big spikes.
John Luke:
It’ll be interesting to see how that plays out, moving forward.
Derek:
That’s another one on the VIX if anyone wants to touch on that one.
JD:
Yeah, so tied into that, we just got a question on, you mentioned hedging. Hasn’t the cost of hedging increased? It has increased, but we do a lot to reduce the size of hedging. Again, this is probably more than you’re asking, but if you think about where you can allocate capital right now, we’re choosing to allocate capital to more equities that have return drivers, and we think that’s a stronger engine. We always use the David Dredge analogy, equities are the stronger engine, we’d rather have more of the stronger engine. And then, our hedging is just really strong breaks, rather than the alternative is, what we’ve all been trained to think is, well, you ratchet risk up by owning more equities and less bonds. You ratchet risk down by owning more bonds, less equities, and we think bonds are a very poor engine to drive returns.
JD:
It’s poor enough that it doesn’t even need breaks, in our opinion at this point, so we choose to forego bonds, as much as possible, and own stocks with better breaks. So, with that said, there’s always going to be a drag to hedging. Whether the VIX is at two or the VIX is at 200, doesn’t matter. There’s going to be a cost to hedging. We know that, we build portfolios with that in mind, but specifically to reduce the cost, what we always say is, yes, it has gone up, but if you are hedged going into an environment of rising cost to hedges, you’re benefiting from that as well. When you’re monetizing and rolling, you’re selling into the elevated prices to buy, as well, and it’s a different conversation, than saying it’s the silly analogy of, you buy home insurance before your house is on fire, you can’t really buy it when your house is on fire. That’s how we’re always going to buy insurance. Hedging can be viewed as a form of insurance.
John Luke:
Yeah. Another lever too, like JD mentioned earlier is, you can also sell covered costs for instance, to help fund some of the cost of that insurance. That’s one of the levers that we’ve used or tools that we’ve used in the portfolios, to really generate another type of uncorrelated return driver, but also help fund some of that hedging or insurance.
JD:
We try not to make… We want this to be more conversational and answer questions, and just kind of talk, but we’ve got all the charts. We’ve produced more content in the last two months, than I think we’ve produced in the last 10 years.
Derek:
Yeah, this is another one. We had a couple VIX charts up, day-to-day, it’s been a pretty wild year. We haven’t seen anything like this, this is up there with all the big… Those are pretty famous years, that none of us, no one really wants to remember. You could also say they laid the groundwork for good opportunities ahead, so I don’t know if anyone has any additional comments or thoughts on that, but doesn’t seem to be changing.
David:
We haven’t really seen a move in the VIX yet, but if you look at the price movement throughout the entire year, and obviously this chart’s showing it that close to 25% of the day, so far this year have traded [inaudible 00:31:00] day of 1% or more. I think our minds through quantitative easing, have been trained behaviorally, to think about things from a V-shaped recovery or a [inaudible 00:31:10] shaped downturn. So, upswings and down swings happen very, very fast. But, if you look at the span of this year, the market is down 23%. But, look at the intro market throughout this entire year, the different periods of changes of actually price of the S&P 500, we’ve had four or five positive price moves of greater than 5% so far this year, we’ve had two greater than 10%. So, we’re not seeing that swoosh down in the market we saw during COVID, it’s been more of a stairstep approach, yet there’s still a lot of volatility underneath the hood of the market, especially if you even look at the individual sector levels.
JD:
And so, one question, is there any good explanation to why VIX is not higher? It sure seems equity volatility is high, but don’t fully understand why it does not relate. Yeah, there’s a good explanation. We think a lot of people are hedged coming into the year, so there’s a difference. Remember, VIX is not like… VIX is just a read on the level of premium being paid for puts in the market. That’s probably not the perfect technical definition, but it’s just not a direct translation to what’s actually happening in the markets, it’s what people are willing to pay. VIX goes up when people are willing to pay anything for protection. And so, like what I said earlier, for the most part, there’s a lot of hedges in place, and we’re starting to see some of that drop off. But, if there’s a lot of hedges in place and you get movements lower in the market, when you’re monetizing hedges and rolling to something else, that’s different from not having hedges in place and scrambling to get them.
JD:
And so, I think that’s probably why VIX has been 35 or lower, or whatever the number is, because most people have owned hedges. Coming into this year, more people have owned hedges than not, and this is more of a subjective statement, but we haven’t really had any event of a single company event, there hadn’t been anything that’s like… You hadn’t had a Lehman collapse, or something like that. It’s just been a grind blower. There’s not been that one thing where FedEx comes out and pulls all guidance in the stocks down 25%, but it’s not like you’ve had some serious liquidity issues in the market, yet. That is interesting despite all the things that the significant rise in rates and some of the things we have going on, all over the globe. I don’t think VIX will stay contained forever, is my point.
Derek:
We have a few questions on bonds, which anybody that’s been following us or talking to us, knows for years we’ve been saying bonds, we hate them, we hate them, we hate them. They yield nothing, we don’t think they’re going to even protect. What if inflation kicks in? Well, rates are a little bit different now. You can get 4% on a one year [inaudible 00:34:22]. A couple of the questions are directly related to, are we finding bonds attractive? Are we doing anything there? That’s a good topic to cover, I think.
John Luke:
Yeah, in strategies where we’re forced to own bonds, we were very light, in terms of duration positioning coming into the year strategically, because we didn’t know that rates were going to rise to this extent, but we thought that they were going to go up. But, also the inflationary picture has been more robust than I think anyone expected, as well. So, the biggest thing as being a bond investor, is that your yield offsets the negative impact from inflation, that real yield component. And so, it’s really sort of a call, based off of what you think the long term rate of inflation runs at.
John Luke:
And so, bonds are definitely more attractive than they have been, but I think that you’ve got to be selective, because just like we mentioned with the VIX and volatility, you also haven’t really seen credit spreads blow out this year, which has been pretty eyeopening, in proxy with what JD said. There hasn’t been an event that really led markets to have that blow off top or huge dip lower. So, yields are getting more attractive. I think at some point, they’ll be at levels that are just too hard to turn down, but inflation is still a problem. You’ve got really four drivers of inflation, products and transportation, which is supply chain related. And then, you’ve got labor and energy, and while the two cyclical parts of inflation probably has peaked, the structural parts of inflation with labor and wage pressures and cost of energy, is still debatable.
Derek:
I think one of the fascinating things that you just mentioned too, is that credit spreads have not blown out. I didn’t get to it yet, but I know there’s a ch… This one. Yeah, so the earnings estimates have not really dropped. So, the entire drop, 20 to 25% in both stocks and bonds has come from purely, from interest rates going up. None of it has been… I can’t say none, but it’s not really been fundamentally driven, or at least there hasn’t been fundamental triggers for it yet. So, I’m just curious Dave, because you refer to this chart a lot, is that another risk that has not yet been exposed?
David:
I think I saw a question too on Fed pivots, so I’ll try to dovetail into that also. So Brad, myself, John Luke and Joe Shakur on our team, we did kind of a research, a study looking at historically what has been the average immediate decline in earnings per share during the recession. It came out to be about 20%. Okay? If you expect there to be a mild recession, maybe you see a 15% to 18% decline in earnings per share. But, so far earnings, per share 420, 23 and to caveat that is once June hits, the market starts focusing on 2023 earnings, not 2022 earnings, so that’s just a heads up. But, we’ve only seen a 3% decline so far, earnings expectations for next year. So, I do think that if you look at the price to earnings valuation metric, price is on top, earnings is on the bottom.
David:
Everything that we’ve seen, and we’ve talked about this multiple times as well, all the data degradation in the market has come from the price aspect, the numerator, not the denominator of earnings. I think a lot of people expected that shoe to fall back in Q2, yet we did see sales growth of 12% and earnings growth year of year of 8%. So, showing that inflation is driving more spending, but it’s starting to take effect on the margin, as a whole, and when it accounts to… But yes, so I think that the next shoe to fall is going to be focusing on earnings per share, and if there’s one factor that tends to drive the S&P 500, the market itself, it actually tends to be earnings revision. If you look at a statistical analysis from correlation, if you get in the financial world a single variable greater than 0.4, that’s pretty significant.
David:
But, if you look at the correlation between earnings revisions versus the S&P 500, that correlation is actually 0.8. So, it is very, very significant. So, I think the market’s going to be focusing on that aspect and moving forward through the end of this year, about 2023 revisions pretty closely. But, if you dovetail that into a, will there be some type of Fed pivot? Well, we’ve known and learned that the Fed has never made a Fed pivot when the degradation in the market, from a price standpoint, has strictly come from a valuation compression. They’ve always done it when you’ve seen some type of earnings declined substantially occur, and we have not seen that yet. I think a point that John Luke told me about a few months ago, the Fed has always made a pivot when there has been a technical bear market via the S&P 500, and we are in a technical bear market right now.
David:
Yet, the Fed continues to not pivot, they continue to increase rates. We’ve had what three, four meetings in a row, 75 basis points are higher, another potential 125 basis points moving forward. So, it shows to what exactly what John Luke said, the Fed is very embarrassed that they called inflation last year transitory, and they want to focus on getting inflation down, the one of their two aspects of their dual mandate, even if it may come at the degradation of trying to kill as many job openings as possible, or even jobs themselves. So, I don’t see a Fed pivot happening here, in the near term.
John Luke:
That real rate chart that looks at the Fed funds rate minus CPI inflation, which is sitting right now at negative 5.01%, it’s hard to argue that you’re in restrictive territory with the negative 5% real yield level, which is something that we continue to watch, and obviously, as inflation moves lower and the Fed fund rate moves higher, that’ll get closer and closer to parody. But, the other piece of that analogy that Dave mentioned was, the Fed has never stopped hiking rates without getting above the inflation rate. And so, in terms of, you can look at different levels of what the real inflation rate actually is, but they’ve still got ways to go.
Derek:
Question allocation wise, what do you think at this point, what kind of changes could be suggested, considered, discussed, either in our models or in some of the collaborative models we do with advisors? Anyone dare take that?
John Luke:
Yeah, Dave, I think like Dave mentioned on the earnings and we’ve highlighted it a few times, where companies that have high quality characteristics are typically more able to pass through cost increases, price increases to us, as consumers, and I think just looking at the high level of, we’re quality biased at heart as far as the equity allocations go, but I think that it will be more and more prudent as financial conditions continue to tighten and stay tightened, to really lean on quality allocations throughout the model portfolios. That’s something that we are continuing to consider as far as the portfolios go.
David:
Before we probably talk about fixed income, in regards to allocations in the current environment, if you look at a lot of our models, we have a substantial overweight to US small caps. So, we’re looking at a study and it recognized that if the earnings per shares fall for the S&P 500 by 30%, that takes the S&P 500’s valuation back to its 50th percentile. So, basically, it’s median historical valuation. If you look at small caps, if you actually increase earnings per share by 30%, that takes you back to where small caps have historically traded. Small caps tend to trade at a 4% premium to large caps, but right now they’re trading about a 30% discount.
David:
So, I know we’re all talking about the potential for a recession, the potential for a global slowdown in growth i.e. earnings, it kind of feels that the small cap has been somewhat overdone, that it’s already pricing in, some type of a recession, so that’s why you’ve seen some of our models start to really increase the exposure into small cap, because we believe that it’s insulated. The valuation is there and we know that over longer period of time, as JD alluded to at the beginning of this call, valuations matter. I’d rather buy something at a cheaper discount than a higher discount, whether it’s on an absolute level or a relative level.
JD:
I would to kind of hopefully ease some of any fairish tone that we may have, I do think from a client perspective it’s important to always have that… We always talk about rear view versus windshield. The windshield look is getting better. It’s getting better with rates coming up, there are things out there in the equity space that are… Valuations are looking attractive and not in general at this point, but there’s certain stocks that we absolutely love, that are trading at prices and valuations that we think are really interesting. You’re starting to see more of that. And so, the simple thing for clients that I would communicate is, go back to the chart that we showed earlier, where you’re looking at an S&P down over 20 and AG down nearly 20. For that to play out again, that math is just not realistic to think that that could happen again.
JD:
Now, I’m not saying that it can’t, but I think that your bonds are going to start being more of a bond-like return profile, meaning less downside. We don’t love them, because I think the longevity risk of owning too many bonds is still real. But, on the equity side, if you actually do get more damage on the equity markets and earnings are relatively stable, if you enter a recession, earnings will come down, to what extent we’re not sure, but there’s going to be value everywhere that’s attractive. And so, I think that’s the message that I would be sending to clients is, just when the forward looking returns are really, really attractive for a client, I think the majority of damage is behind us, and they have to keep the forward looking view to realize that, as bad as headlines may sound right now and what could happen, your ability to compound capital, its efficient rates to maintain lifestyle or improve lifestyle, is actually getting… It’s a much greater task.
JD:
Our hardest thing, I’m going off script a little bit here, but our hardest thing over 2019 and 2020, before the world got crazy was like, it was hard to be excited about anything, because we were worried about fixed income, equity valuations were outrageous. Now, we’re not in that world, now we’re in a completely different world where the conversations are different, but also the forward look is more attractive. Not saying it can’t get worse from here, but there’s been a lot of improvement to what could happen in the future for our ability to compound capital.
Derek:
Awesome. Well, we’re at 45 minutes, which is long for us on these recorded calls. Obviously, we have tons of material. The charts we put out every week are, I think are a good source for some of the things that we’re looking at right now. And so, as we get into the end of the quarter, I guess probably in a week, two weeks, we’ll have all of the more formal reports that we put together, the actual Q3 recap, the Q4 preview, all that kind of stuff. We just wanted to jump in a little bit earlier and some of you will be having direct calls with your teams about all this stuff, like we do every quarter. So anyway, thanks. Appreciate everybody hopping on and just talking through some of this stuff. It is really… It’s an interesting environment and we’re just about to get into Dave’s area of earnings season. So, I don’t know when that kicks off. Probably 9th, 10th of October, something like that, soon.
David:
When the bank starts.
Derek:
We’ll at least have a couple weeks of not Fed every day, I’m guessing. There may still be some Fed speak, but it seems like they’re all right now, they’re all talking this week, the Fed meetings behind us. The next one’s not till near the election.
David:
November 2nd.
Derek:
Yeah.
Derek:
We’re going to find out a lot in early October, I guess, about if FedEx is the exception or the rule. So, that’ll probably dictate a lot of what goes on, going forward. Anyway, appreciate y’all. Thanks for tuning in and we’ll record this thing up and get it out.
JD:
Thanks everybody.
Derek:
There you go.
John Luke:
Have a good one.
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